P/E Can Be Misleading
November 8th 2006 14:41
In his most interesting book "The New Money Masters" John Train relates this consideration that Peter Lynch makes: Price to Earnings can mislead, meaning that they can induce the investor to think that a particular stock is too highly priced, if that’s the case, and so undesirable.
Then he goes on to demonstrate his view: if you buy company A, which for us Australians could be Westfield Holdings, and company B, which could be National Foods, both for the sake of demonstration having Earnings Per Share of $1 on a starting point, being WES P/E 20 times and NFD 10.
If WES increases its EPS by 20% in the first year and every year thereafter and NFD increases by 10% then the EPS figure at the end of year one will be: WES = $1.20; NFD = $1.10.
Now watch what happens after compounding EPS for ten years: WES = $6.19; NFD = $2.59.
At 20 times earnings WES is valued $123.80, ($6.19x20) and at 10 times earnings NFD is valued $25.90, ($2.59x10).
Even if WES falls to a more reasonable multiple of 15 its value is still $92.85, ($6.19x15), miles ahead of NFD, ($25.90).
So, the moral of the story is that you shouldn't worry too much about high P/E if the company in question has a high EPS growth rate.
How beautifully simple!
Then he goes on to demonstrate his view: if you buy company A, which for us Australians could be Westfield Holdings, and company B, which could be National Foods, both for the sake of demonstration having Earnings Per Share of $1 on a starting point, being WES P/E 20 times and NFD 10.
If WES increases its EPS by 20% in the first year and every year thereafter and NFD increases by 10% then the EPS figure at the end of year one will be: WES = $1.20; NFD = $1.10.
Now watch what happens after compounding EPS for ten years: WES = $6.19; NFD = $2.59.
At 20 times earnings WES is valued $123.80, ($6.19x20) and at 10 times earnings NFD is valued $25.90, ($2.59x10).
Even if WES falls to a more reasonable multiple of 15 its value is still $92.85, ($6.19x15), miles ahead of NFD, ($25.90).
So, the moral of the story is that you shouldn't worry too much about high P/E if the company in question has a high EPS growth rate.
How beautifully simple!
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Comment by Howard
Real Crash